If someone mentions the word recession or depression, one of the first things that comes to mind is deflation, wherein nominal prices decrease. For example, when a $1,000,000 house falls to $650,000. Less common is associating a recession with rising prices.
When this happens in an economy, it’s called stagflation. This is a word that has gained relevance and popularity since generationally high inflation took hold following 2020-21.
Making Sense of Stagflation
I had a conversation a couple of months ago in which I proposed housing prices could enter a recession in the following 18-24 months, yet prices could remain flat by the end. How is this possible? If general inflation outpaces any rise in home prices, inflation-indexed (real) returns fall.
To help make more sense of this, it should be noted that even if inflation-indexed home prices fall, not all cohorts of the population would necessarily gain purchasing power in the context of real estate. For this, it depends on one’s asset and income exposure. For example, wages in certain cohorts may remain somewhat stagnant relative to changes in real estate. The stock market may lag behind or lead ahead, and commodities may soar ahead (not all commodities per se).
Additionally, it is important to note that given the extremely cyclical nature of not only inflation but commodity prices – which are basically one in the same in a sense – it is common for many to buy at the peak and ride the downtrend.
This makes any “inflation-indexed” fall seemingly invisible to the individual whose purchasing power is falling in a commensurate or greater fashion. They can’t buy more or fewer houses than they could before (discounting interest rate changes). What is often seen during extreme inflation are rapid losses in wealth among large sections of the population, dependent on their exposure to inflation-exposed assets, and where their income streams come from.
Defining Stagflation Risks
Stagflation is characterized by low or stagnant growth in the economy coupled with high inflation. To demonstrate the stagflationary phenomenon of the 1970s, look no further than an inflation-indexed stock market chart. Though the stock market is rarely an accurate one-to-one metric for representing changes in the productive capacity of the economy, it may prove relevant for investors to see.
The general idea for minimizing stagflation risks is simple. Position oneself (assets + income) so that one’s own purchasing power does not fall excessively with inflation-indexed falls.
For the more active investor, it is possible to profit handsomely during and directly after a highly inflationary period, though this is inherently reserved for a select minority (depending on their knowledge, luck, job, and contacts).
A question that should be considered is the following: What’s a more extreme version of stagflation? Both are characterized by recessions, but hyperinflation starts at 50% inflation per month. Sometimes, a state of inflation in-between stagflation and hyperinflation is characterized as “galloping inflation”.
Now, how does one beat stagflation?
In the simplest terms, it is a matter of anticipating inflation and positioning one’s wealth and investments accordingly. Of course, the alternative is simply keeping indexed with the market as a whole, while dollar cost averaging along the way.
Such a strategy could range from a slight rebalancing in favor of assets historically resilient toward inflation, to a major repositioning in assets such as gold and silver.
A risk, however, is being wrong about when, if, and how long stagflation will grip the economy. If that proves the case, underperforming the market is likely.
If one applies Ray Dalio’s “holy grail of investing” principle, it may help investors’ portfolios perform well during stagflation. Dalio’s strategy revolves around diversification, in which a basket of 15-20 uncorrelated assets are chosen and weighted strategically within one’s portfolio.
At the same time, a pure focus on business, like Peter Lynch or Warren Buffett, with less concern for whats going to happen with the economy, or anticipating inflation is an effective strategy if you have the skills at your disposal to effectively value individual situations, as well as understanding businesses that would perform more poorly in an extended inflationary scenario (which can be characterized by a see-saw pattern, between inflation, disinflation, and deflation).
Buffett says to avoid businesses that require constant large reinvestments to grow and have little flexibility to raise costs enough if necessary.
Beating Stagflation with Precious Metals
When a currency rapidly loses purchasing power, a propensity to spend occurs. This happens in the context of stock market rallies or bull markets, in that the purchasing power of the dollar falls relative to the stock market index.
Fearing of missing out (“FOMO”) drives prices further. It can be difficult to sit on dollars when the markets are consistently trekking upwards. On the other hand, in a bear market, holding dollars is an easy decision for many.
During stagflation, people may opt to utilize or invest in a foreign currency. Usually, this is the U.S. dollar. However, if the USD enters a highly inflationary cycle, the safe haven assets gold and silver may opted for by a significant number of entities and individuals. This could drive significant price rises in both nominal and absolute terms.
Managing Commodity Exposure to Beat Stagflation
A potentially riskier strategy sometimes adopted during rapidly rising inflation conditions is to take on outsized levels of debt and let it inflate away. It is worth noting that this is effectively what some have done in real estate over certain periods when prices rose rapidly, even if the general economy did not experience very high inflation. This strategy runs the risk of being left with high-interest debt in a deflationary or low-inflation environment.